Martin Place has also indicated that if its cash rate were to increase by a total of 3.5 percentage points, “at least 60 percent of borrowers with fixed rate loans would see an increase of at least 40 percent when they expire”. .
This is an interest rate shock that was never meant to happen. Before October 2021, banks were only required by the Australian Prudential Regulation Authority to apply a mortgage repayment test that used an interest rate that was just 2.5 percentage points above the product’s actual rate. The RBA has already increased its target cash rate by more than this (ie 2.85 percentage points). Market pricing is expecting the RBA’s total interest rate increases to reach 3.75 percentage points.
In October 2021, APRA put the RBA on the prudent footing, and raised the minimum repayment test buffer for banks to 3 percentage points. (Most non-bank lenders still unhappily use a buffer of 2.5 percentage points.) However, this will be insufficient to counter the circa 350-400 basis point interest rate shock that the RBA will impose on borrowers.
Put differently, many borrowers who took out really cheap home loans in 2020 and 2021 on the assumption that the RBA would not raise rates until after 2024 will now face mortgage rates that are 40 per cent more than the their lender’s maximum. they thought they would have to serve forever in their lifetime (ie through the APRA stress test).
The majority of fixed rate loans taken out in 2020 and 2021 were at mortgage rates between 1.75 and 2.25 percent. With more than one in five Aussie home borrowers moving from fixed rates to variable rates by the end of 2023, the interest rates those borrowers will pay will more than double to 5-6 per cent.
In contrast to most other nations where the majority of loans are long-term fixed rate products, monetary policy in Australia directly affects almost all loans in the short term. This is also why the RBA’s rate changes have a much greater and more immediate impact on our housing market compared to overseas peers.
One key question pressing the RBA is how much the record rise in the cost of capital will affect consumers’ free cash flow (or their disposable income). This is critical to the outlook since consumer spending accounts for about 50 percent of overall economic growth.
Using RBA data on mortgage-backed residential securities, it finds that more than 52 per cent of all borrowers will see their “spare cash” fall by between 20 per cent and more than 100 per cent, assuming its target cash rate rises to 3.6 percent. percent.
Spare money is defined by the RBA as the income the borrower has left after paying mortgage repayments and “essential living expenses”.
15 per cent of all borrowers will have negative cash flow in the RBA’s base case. That means they are at very serious risk of defaulting on their loan repayments.
23 per cent of all borrowers – or more than one in five – will reduce their spare cash by between 60 per cent and more than 100 per cent.
Almost a third of borrowers will see their free cash reduced by between 40 per cent and over 100 per cent.
This is predicted to lead to a huge drop in household spending if the RBA keeps the cash rate at 3.6 per cent next year. Note that this is actually slightly below current market pricing, which is expected to top out at a final cash rate of 3.85 percent by mid-2023.
Slower rate increases
The massive decline in Aussie household savings is almost certainly one reason the RBA is comfortable slowing the pace of interest rate rises and signaling an early pause to allow for the cumulative effect of the changes consider this.
Given the multi-month delay between the RBA raising its target cash rate and lenders going through these increases for borrowers, it only takes time for the transmission to actual consumer spending, demand and price pressures. And it will take many more months for these changes in household behavior to become evident in official economic data, which are reported on a monthly or quarterly basis.
It is clear that families realize that their cash flow is about to go to waste. This is reflected in the consumer confidence data, which is worse than the levels recorded during the GFC. And it’s also reflected in the real-time daily home price indices reported by CoreLogic.
National house prices are falling at a record annual rate of 14 per cent based on the last three months of data from CoreLogic, with a total drawdown of 7.4 per cent from the high five capital index in May 2022.
The epicenter of the biggest housing crash in Australia’s modern history has shifted from Sydney to Brisbane, where prices are falling at an incredible annual rate of 20.3 per cent (Brisbane values are already down 7.7 per cent peak-to-trough so far).
Sydney property values have fallen the longest, falling a whopping 11.1 per cent from a peak in absolute terms. Unfortunately for homeowners, Sydney property values continue to decline at an annual rate of 17 per cent based on price movements over the past three months.
This is a secondary way in which monetary policy affects behavior – through a large negative wealth effect.